estate planning with section 1031 exchanges: structuring like...
TRANSCRIPT
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Estate Planning With Section 1031 Exchanges:
Structuring Like-Kind Exchanges
of Investment Property Complying with Complex IRS Requirements to Achieve Short- and Long-Term Tax Savings
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, SEPTEMBER 1, 2015
Presenting a live 90-minute webinar with interactive Q&A
David M. Hellman, CPA, Attorney, Law Office of David M. Hellman, San Rafael, Calif.
James Miller, Senior Vice President, Investment Property Exchange Services, Tempe, Ariz.
Stephen L. Robison, JD, LLM, President, Strategic Property Exchanges, Cincinnati
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IPX1031® - www.ipx1031.com - 5 -
Jim Miller Western Operations Exchange Counsel
[email protected] 602-850-8630
Overview of IRC § 1031
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• If you sell a property you pay tax on the Gain (I.R.C. §1001)
• In a taxable sale, recognized gain equals: Net Sale Price (Gross Sale Price less sale costs
[commissions, etc.]) • Minus Tax Basis
Taxes in a Sale
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• A 1031 exchange permits the deferral of • Capital Gain Taxes (15% to 20% Federal and ___% State) • Depreciation Recapture (25% Federal) • 3.8% tax on certain investment income imposed The Affordable
Healthcare Act
• Example – Sell a property for $1 million that has no debt and has been fully depreciated; assume a combined tax rate of 25% and purchase replacement properties with a 75% LTV ratio.
Sell or Exchange? – Run the Numbers
TAXABLE SALE 1031 EXCHANGE
Net Equity 1,000,000 1,000,000
Combined Taxes 250,000 -0-
Equity to Reinvest 750,000 1,000,000
Proposed Acquisition 3,000,000 4,000,000
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• In a nutshell, a 1031 exchange allows an investor to sell their old investment property and use all of the equity (not just the “after-tax” equity) to purchase their new investment property • Making change
What is a 1031 Exchange?
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• Exchange • Qualified Use • Like Kind
Statutory Requirements
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• The act of substituting one thing in return for another – reciprocal giving and receiving
• Satisfied by a direct trade (swap) • Satisfied with Q.I. by the Exchange Agreement
Exchange
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Satisfying Exchange Requirement with a QI
Exchanger (Investor)
Buyer QI $ $
Seller
Relinquished Replacement
Exchange Agreement
R P L
R L Q
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• According to the IRS “Qualified” means… • That you are NOT Disqualified • Who is Disqualified?
1. The Exchanger; 2. A related party to the Exchanger; or 3. An agent of the Exchanger
– Agent is defined as an ex-employee, attorney, accountant, investment banker or broker or a real estate agent or broker, within the last two years
• Everyone else is “Qualified”!
What does “Qualified” Mean?
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• Both the Relinquished Property and the Replacement Property must be held for a qualified use, which can be either: • Investment Property; or • Property held for the productive use in a trade or
business
Qualified Use
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• Not property held primarily for sale • This is inventory • Focus on the taxpayer’s intent and actions
- Did they acquire to sell or to operate it or have it for a long term hold
• Not dealer property • Property held for sale in ordinary course of
business - For example a builder selling homes or developer
selling lots • This is ordinary income
Qualified Use (continued)
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• What constitutes like kind real property is very, very broad
• The following types of real property are all considered to be like kind and can be exchanged for each other: • Land, commercial buildings, farms and ranches, rental
homes, tenancy-in-common interests and leases of 30 years or more (including options).
Like Kind - Real Property
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• Qualifying personal property (held for investment or business use) can be exchanged for property of like kind • Property deemed to be like kind if in the same
Product Class or General Asset Class
Like Kind – Personal Property
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• Personal property used in a business • Construction or farming equipment, printing presses,
etc. • Personal property held for investment (vs. used in
a business) • Artwork, Coin Collections, Collector Cars, Gold
Bullion…
Personal Property Exchange Examples
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What is NOT Like Kind?
Delayed Exchanges
Exchanger (Investor)
Buyer QI $ $
Seller
Relinquished Replacement
0 45th day 180th day (or tax filing deadline)
Identification Period Completion Period
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Build–To–Suit (Continued)
Exchanger (Investor)
Buyer QI $ $
Seller
$1M $600K
Relinquished Replacement
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• Opposite of a forward exchange • Exchanger wants to acquire Replacement
Property first and sell Relinquished Property later • When to use
• Relinquished Property falls out of escrow • Exchanger finds Replacement Property and is ready
to close before
Reverse Exchanges
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• Most common • Phase 1 – EAT gets $ from Exchanger or 3rd party
lender • Acquires Replacement Property from Seller
Reverse Exchange Structures
(Replacement Property Parked)
EAT Seller $
RPL
• Phase 2 – Simultaneous Exchange
Reverse Exchange Structures
(Replacement Property Parked - Continued)
Exchanger (Investor)
Buyer QI $ $
EAT (uses $ to repay loan)
Relinquished
Property
Replacement
Property
- 23 -
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• 45 & 180-day timelines still in effect • Time starts when EAT acquires parked property • Within 45 days – Exchanger must identify Relinquished
Property • 180 days – EAT must transfer parked property
• Can also do a Relinquished Property Reverse • Similar procedure except the relinquished property is
parked with the EAT (instead of the replacement property)
Reverse Exchange Structures
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Jim Miller Western Operations Exchange Counsel
[email protected] 602-850-8630
Overview of Business
Entities
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• Corporations • C Corporation • S Corporation
• Partnerships • General • Limited
• Limited Liability Companies (LLCs)
Entities Discussed
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• “C” and “S” Corporations are formed the same way • Mechanics of Forming a Corporation
• One or more people act as incorporators and file documents with the applicable state agency - Generally Articles of Incorporation
• Bylaws • Govern the management of the Corporation
- Including signing authority
• Management • Day to day – officers • Long term - directors
Corporations
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• Creating an “S” Corporation • File Form 2553 with the IRS
• Why form an S corporation • Avoid “Double Taxation”
Legal and Tax Differences
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• Tax Rules • Income
- C Corporations (Double Taxation) • 1) Profits taxed at corporate level (35%) and 2) dividends are
taxed to individual as capital gain or ordinary income - S Corporations
• Corporate profits “passed through” and taxed at the individual ordinary income tax rates
• Loss - C Corporations
• Set off against gain - S Corporations
• Passes through to individual shareholder’s return
Corporations (Continued)
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• Legal • Partners are personally liable for partnership obligations • A partnership can be created without a partnership
agreement
• Tax rules • The partnership files a Form 1065 and gives each partner
a K-1 - Partnership profits and losses “flow through” to the individual
partner and taxed on the individual return
General Partnerships
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• The IRS does not recognize an LLC as a separate entity (for federal tax purposes) • It is a creation of state law
- Is a separate entity (from its members) for state law purposes • Liability, ownership of assets, ability to enter into agreements, etc.
- For federal tax purposes, it will be treated and taxed as a corporation, a partnership or a sole proprietorship
- LLC can file Form 8832 to elect to be treated as a corporation • Can file further election to become an “S” corporation
LLC Tax Treatment
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• If no election – default rules apply • 1 member (Single Member LLC)
- Is a disregarded entity and files a Schedule C to the individual’s Form 1040
• 2 or more members - Will be treated as a partnership and will file a
partnership tax return (1065)
LLC Tax Treatment
Case Study – The Family Farm
1031 Sell Buy
Mom & Dad sell
the family farm
and buy three
properties near
the children Child #3
Pays each child to
manage property for them
Puts each property in a
revocable living trust
Child #2
Child #1
- 33 -
David M. Hellman, Attorney & CPA 851 Irwin Street, Suite 205 San Rafael, CA 94901-3343
(415) 457-4411 [email protected] www. davidhellman.com
TOPICS TO BE COVERED:
1. Unified Credit and Estate Tax Rates on Excess Estate Taxes
2. Life Time Gifts Without Restrictions
3. Life Time Transfers With Restrictions
4. Transfers at Death
5. Difference between Step up in Tax basis in Assets versus Business Entities that own Assets
6. Distributions in redemption of stock to pay Estate Taxes
7. Valuation of Small Businesses
8. Planning Objectives
Overview of Estate and Gift Taxes
35
Unified Credit and Estate Tax Rates of Excess Estate Assets
• 2015 Unified Credit Exclusion Equivalent is $5,430,000
• Tax Rate for Taxable Estates is 40%
36
Life Time Gifts Without Restrictions
• Spouse
• Charities
• Under Annual Exclusion $14,000 Per Donee
37
Life Time Transfers With Restrictions • All non-spouse, non-charity gifts in excess of $14,000 per Donee
38
Transfers at Death • 40% Rate on Excess over Exclusion
• Assessed Pro-rata to assets/to specific distributions/or from residue
39
Difference between Step up in Tax basis in Assets versus Business Entities that own Assets
• Directly owned receive new Fair Market Value basis
• Community property assets receive new basis on entire
asset
• Entity receives new basis. Entity’s assets do not receive new basis
• Make IRC Sec. 754 Election for Partnerships and LLCs taxes as Partnerships—additional basis for internal assets
40
Distributions in redemption of stock to pay Estate Taxes
• IRC Sec. 303—business at least 35% of Adjusted Gross
Estate
• Generally must be done 3 years + 90 days after filing Estate Tax Return
• Stock owner bears costs and income tax consequences of sale
• Stock sale treated as capital gain/loss not dividend
41
Valuation of Small Businesses
• High IRS Audit Issue
• Value underlying assets of entity
• Then Value interest of decedent • Discount for lack of liquidity
• Discount for lack of marketability
• Discount for lack of total control or minority
interest
42
Planning Objectives
• Most Estates not taxable—focus on new income tax basis
• Allocate assets to QTIP Trust and use Portability (DSUE) so new basis on both spouses’ deaths
• 1031 Exchanges to accomplish • Senior Generation owning assets with desired new
basis for later sale or higher depreciation • Do with younger generation or closely held
business • Related Party Rules
• Both parties exchange • Two year holding period
43
TOPICS TO BE COVERED:
1. Purchase and Sale
2. Split Interests
3. Appreciated Assets
4. Distributions Treated as Dividends
5. Non Liquidating Distributions
6. Liquidating Distributions
7. Divisive Reorganizations
8. Split Ups
9. Split Offs
Transferring Assets Into and Out of Business Entities
44
PLANNING PRE-DEATH FOR BEST POST-
DEATH RESULTS and SUCCESSION PLAN
BE CREATIVE
LOOK AT ENTIRE FAMILY SITUATION
GET CONCENSUS ON DESIRED POST-DEATH PICTURE
THINK OUTSIDE THE BOX
45
Purchase and Sale Taxable gain unless selling at or below basis:
• Use IRC Sec. 754 Election if available to reduce gain on sale
• Sale of Small Business Stock after owner’s death should have new basis
which should minimize gain
• Use 1031 Exchange of assets in business into other like-kind assets 46
Split Interests
• Generally for CRUTS/CRATS--non-taxable transfer, some charitable deduction, annual income in form received by entity
• Alternative
• Do 1031 Exchange of Asset to get new desired asset • Donate any “boot” to charity • Same or better income than CRUT/CRAT • Preserve family wealth by not transferring asset on death
47
Appreciated Assets • Three components of gain
• Return of Basis Tax Free • Depreciation Recapture • Capital Gain on Sale Price over Original Cost
• If desire to replace Asset, use 1031 Exchange if available
• If desire is to raise cash, then borrow on asset or other assets
48
Distributions Treated as Dividends (Corporations)
• Proportionate to Shareholdings • Qualified Dividends get Individual
Shareholder treatment at capital gain rates
• Corporations get percentage reduction in amount recognized
• Stock and related distributions do not qualify for 1031 Exchange treatment. Tangible assets received may qualify for later 103 Exchange.
49
Non Liquidating Distributions
• Corporations • Distributions generally treated as dividends • Insufficient Earnings & Profits portion treated as return
of capital • Property received not available for 1031 Exchange. Tangible Assets received may be used later for 1031 Exchange.
• Partnerships (including LLCs treated as Partnerships) • Distributions are either of current income or return of
Capital. • Property received is not available for current 1031 Exchange.
Tangible Assets received may be used later for 1031 Exchange.
50
• Other Entities—Trusts • Distributions are a flow through of income received or return of
Capital
• Property received is not available for current 1031 Exchange.
Tangible Assets received may be used later for 1031 Exchange.
51
Liquidating Distributions
• Corporations (including LLCs treated as Corporations) • Generally Treated as a capital gain transaction • Property received is not available for current 1031 Exchange.
Tangible Assets received may be used later for 1031 Exchange. • Partnerships (including LLCs treated as Partnerships)
• Unless partner’s capital is negative, distribution will be non-taxable and partner’s basis is allocated to assets received.
• Property received is not available for current 1031 Exchange. Tangible Assets received may be used later for 1031 Exchange. • Other Entities—Trusts
• Distributions are principal assuming all income has been distributed • Property received is not available for current 1031 Exchange.
Tangible Assets received may be used later for 1031 Exchange.
52
Divisive Reorganizations
• 1031 Exchanges are a good tool to get assets in place for subsequent divisive reorganization • Applies to: Corporations (and LLCs treated as Corporations) Partnerships (and LLCs treated as Partnerships) Other forms of entities
53
Split Ups and Split Offs (Corporate D Reorganizations)
• 1031 Exchanges are a good tool to get assets in
place for subsequent
54
TOPICS TO BE COVERED:
1. Owners
2. Business Interests
3. Valuation Issues
Estate Taxation of Business Entites and Their Owners
55
Owners • Estate Taxation on Worldwide Assets
• Planning Objectives
• Minimize or Eliminate Estate Tax Liability • Get Highest Basis possible for Assets • Post death the family has highest basis possible for
assets they hold
• Planning Tools • Pre-death valuations to understand the estate tax
exposure • 1031 Exchanges to get tangible assets into
appropriate ownership
56
Business Interests • If Business Interest exceeds 35% of value of
Gross Estate, then available for IRC Sec. 6166 election
• Corporate Stock can be redeemed under IRC Sec. 303
• Plan to get increased basis in assets.
• Use 1031 Exchanges if available to move assets to desired ownership.
57
Valuation Issues
• Most litigious issue related to Estate Tax liability
• Closely held business • Value assets of business • Value business interest held be decedent using
discounts if available
• For non-publicly traded businesses, finding comparable market value is primary difficulty
• Planning—Get difficult to value out of Estate using 1031 Exchange to another family member or entity. • Potential audit issue as gift—fully disclose on tax
return and do as early as possible before death
58
THINK OUTSIDE THE BOX
59
Entering into
Exiting out of
Business Entities
to Reduce your Income and Estate Taxes
. Stephen L. Robison, JD, LL.M Taxation
Strategic Property Exchanges LLC
11353 Reed Hartman Highway Suite 300
Cincinnati Ohio 45241
1-800-427-7212
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Improving Cash Flow and Financial Efficiency.
While 1031 exchanges is a well known tool to reduce taxes, 1031 exchanges go far beyond their utility as a tax tool. Section 1031 reflects an overall long term strategy to reach financial, operational and legal structural goals for the client as well as plan for the eventual transfer, sale or liquidation of the current business.
61
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Improving Cash Flow and Financial Efficiency.
• 1031 exchanges provide an opportunity to:
reposition assets for cost reduction and greater growth;
• to provide retirement income; • to transfer the net wealth to the next
generation; and • to enable the next generation to utilize their
inherited capital for the best possible use.
62
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Basic Assumptions
The statistics on death are impressive. Eventually your assets will be liquidated The question is who is controlling these events.
63
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Basic Assumptions
The current Business Entity might not be the best Entity when you Retire or die. While it is common for businesses to focus on the here and now, it is our job as advisors to prompt them to think long term… because the best plans require time, energy and periodic reassessment to come to fruition.
64
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Example: Trucking Company • Owns its fleet in a C Corporation and has <2,000,000> NOL • Operating Company is an S Corporation and just became
profitable after years of losses. • Client wants to sell business in next 10 years. On sale the client
plans to liquidate all of its fleet assets, exchange into new fleet assets and lease to Buyer to generate retirement income. At death, fleet assets will pass to children.
• NOL Tax benefit is trapped in C Corporation and future income will be subject to double taxation. No step up in basis for fleet assets for heirs at death.
• Distribute $ 2,000,000 worth of assets out of C Corporation to a new SMLLC owned by the Client. Corporate level gain is offset by NOL. Dividend income will be offset by depreciation deductions flowing thru to client.
65
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Real Estate Exchanges are Great, but Trade or Business Assets Exchanges are Better Unique Advantages for trade or business assets
• Deferred taxes are eliminated over time
• Assets can be dissimilar and still be like kind
• Optimize holding period to reduce operating
costs and maximize value transfer.
66
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Replacement Cycle Options Taxable Sale at highest value, pay tax and borrow to acquire new assets. Trade assets with dealer at reduced value to cover dealer margin and borrow to acquire new assets. Exchange at highest value with lower debt for new asset.
67
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Having advised clients and their advisors for 25 years regarding 1031 exchanges, there are many misconceptions about exchanges • Some Businesses hold assets until scrapped in
an effort to avoid income taxes at sale but will burdens the company with much higher repair and maintenance expenses.
68
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
• Taxable sale followed by reinvestment results
in no more tax depreciation than exchanges. • Taxable sales results in higher debt and
interest expense, reducing owner equity. • Trading the asset with the dealer on average
costs the taxpayer 20% of the net asset value. • A Trade must be accomplished in one day,
Exchanges can be accomplished over as long as 180 or 360 days.
69
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Cash flow is the life blood of every business endeavor.
Cash Flow pays the bills. Cash Flow is needed to satisfy lender loan covenants. Cash Flow provides the internal funds to invest for growth. Section 1031 Exchanges are the best method for increasing cash flow for any business.
70
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
Taxes, on the other hand, is a form of confiscation by the government and inhibits capital formation and growth. The ability to buy and sell trade or business assets without the imposition of taxes represents an unparalleled opportunity in today’s business environment.
71
Preparing for Growth, Retirement, Wealth Transfer for
the Business Owner
1031 Exchanges, by reducing income taxes, debt repayment and interest expense provides the financial flexibility to reinvest in better quality assets and reduce repair and maintenance costs. The following slide illustrates the financial impact of shortening the replacement cycle by 2 years. The 1031 exchange cost savings enables the Company to purchase more trucks, which increases sales revenue, reduces debt and boosts net asset value, all of which increases the future sale value of the company.
72
Preparing for Growth, Retirement, Wealth Transfer for the Business Owner
73
How to get your assets into and out of Entities to
minimize your overall taxes
• The importance of getting your assets in to and out of
business entities is important for the following
reasons:
– Minimizing Federal Income Tax during the
taxpayer’s lifetime
– Minimizing Federal Income, Gift and Estate Taxes
on the death of the taxpayer.
– Ease of reinvestment by you and your heirs.
74
Initial Formation
There are essentially 3 types of entities for most investors • A separate taxable entity
• C Corporation • Complex Trust • Irrevocable trust
– A limited flow thru entity • S Corporation • Trust • Estate
– A Flow thru entity • Partnership • Limited Liability Company (default) • Revocable Trust
75
How to get your assets into and out of Entities to
minimize your overall taxes
• Business entities are governed by agreements, which are
supplemented by state (and sometimes federal) law.
– The governing document(s) for business entities can be
tailored to meet the specific needs and interests of your
clients including how to withdraw from the entity in the
future.
– In drafting governing documents, it is important to never
rely on the default provisions under your applicable state’s
laws. Even if your client desires the same outcome, always
draft it into the governing document.
76
How to get your assets into and out of Entities to
minimize your overall taxes
• Common Governing Documents
– Corporations: Articles of Incorporation and
Bylaws
– LLCs: Articles of Organization and Operating
Agreement
– Partnerships: Partnership Agreement
– Trusts: Trust Agreement
– Agreements Among Shareholders/Members: Buy-
Sell Agreements, Call-Put Arrangements
77
Initial Formation: Agreements
An entity and its owners enter into one or more agreements, to cover one or more matters.
• buy-sell agreement to control any disposition of the entity’s ownership interests.
• Agreement to manage and operate the business . Including, for example, protecting S status from stock transfers that cause termination;
• Determine how the entity will distribute cash and assets
• Control of the entity. That agreement may take the form of a voting trust or a voting agreement.
78
Initial Formation
The primary characteristics involve:
• Whether there is a recognition of gain or loss on the contribution of assets to the entity or the withdrawal of assets from the entity;
• Whether the owner of the entity can include indebtedness in their tax basis;
• Whether the owner of the entity is personally liable for the business indebtedness.
79
Initial Formation: Corporations
• Corporations are formed upon the filing of Articles of
Incorporation w/ your client’s Secretary of State
Office.
• Provided the incorporators own 80% or more of the
entity when formed, there is no gain or loss is
recognized when property is transferred to a
corporation by one or more persons solely in
exchange for stock in such corporation.
80
Initial Formation: Corporations
• C Corporations permit investment in common stock, preferred stock and debt, allowing its investors to choose how they will receive priority on distributions from the Corporation.
• S Corporations only permit investment in common stock and may own a disproportionate investment in Company debt. Owning debt can be a trap for the unwary.
• Stock issued for past or future personal services is taxed to the recipient.
81
Initial Formation: Corporations
Recapitalizations
Where an entitymay need to be recapitalized a corporation does not realize discharge of indebtedness income when a shareholder makes a contribution of the corporation's debt to its capital whenever corporate shareholders cancel the corporation's debt in proportion to their shareholdings and the corporation does not issue new stock as part of the transaction.
82
Initial Formation: Limited Liability Companies
• Like corporations, limited liability companies are
formed by filing articles under state law with the
Secretary of state and provide limited liability from
debts.
• Like partnerships, limited liability companies are
treated as a flow thru entity under federal tax law.
83
Initial Formation: Limited Liability Companies
The LLC form is appealing to many taxpayers
1. Want flow thru tax treatment
2. Cannot satisfy S Corporation requirements
3. Wants to include the entity's debt in the basis of their entity interest,
4. Want multiple classes of ownership interests, and
5. Distribute assets without triggering gain or loss; or
6. Does not want the limits on management participation by limited partners
84
Initial Formation Partnerships
• Partnerships do not require any specific filings to
come into existence, rather a partnership exists by
operation of law whenever two or more co-owners
conduct a business for profit.
• No gain or loss is recognized by a partnership or any
of its partners when property is contributed to a
partnership in exchange for a partnership interest at
any time during its existence.
85
Initial Formation Partnerships
• Like corporations, services are not considered property.
• The contributions of property followed by a distribution of cash or other property may be disregarded as a disguised sale and the contribution of property followed by the assumption of the contributing partner's liabilities may be taxable.
86
Initial Formation Partnerships
• The transfer of a capital or profits interest in the partnership by the partnership to a creditor in satisfaction of a partnership debt results in cancellation of indebtedness income as if the debt had been satisfied with cash equal to the value of the partnership interest.
• This income is allocated to the partners of the partnership immediately prior to the satisfaction of the partnership debt.
87
Initial Formation: TRUSTS
• Trusts do not require any particular filing to come into
existence.
– Simple Trusts distribute all of their income to their beneficiaries.
Complex Trusts pay tax on their income and distribute their income in
accordance with the terms of the governing document
• For federal tax purposes, grantor trusts are disregarded and
treated as owned by the grantor and irrevocable trusts taxed as
a separate entity.
• The contribution of assets to a revocable trust is generally a
tax-free event.
• The contribution of assets to an irrevocable trust is potentially
subject to federal gift tax.
88
Midstream Investment
• The tax consequences of investments in a business after its formation are
largely dependent upon the type of entity through which the business is run.
• Corporations: possible gain or loss on the contribution of property in return
for stock.
• Partnerships – no tax consequences so long as debt assumption on
contribution of encumbered property does not exceed partner’s basis in
contributed property.
• Trusts – generally no tax consequences on subsequent contribution of
assets to a revocable trust; potential gift tax consequences on subsequent
contribution of assets to an irrevocable trust.
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Distributions of Cash and Assets
Distributions of Assets out of a C Corporation A distribution with respect to stock is a dividend that must be included in the shareholder's ordinary gross income.
Shareholders are not taxed on the current earnings of the Corporation unless an S election has been made.
To the extent that a distribution exceeds current and accumulated earnings and profits, the distribution is treated as a return of capital that reduces the shareholder's adjusted basis in the stock of the corporation. Once the distribution exceeds stock basis, the distribution is treated as gain from the sale or exchange of the stock. At the corporate level, the distribution is not a taxable event and reduces earnings and profits (not below zero).
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Distributions of Cash and Assets
Partial Liquidations of a C Corporation.
Redemptions of noncorporate shareholders in partial liquidation of the distributing corporation is treated as a sale or exchange.
The qualification depends on the nature of the distributed assets, rather than the effect on shareholders' proportionate interests.
A partial liquidation, unlike a complete liquidation, can be
non–pro rata.
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Distributions of Cash and Assets
Section 355 division of Corporate Assets
– Where corporate shareholders desire to go their separate ways
– If a corporation conducts a five-year-old active trade or business and its subsidiary conducts another, Section 355 permits the parent to distribute stock of the subsidiary to shareholders tax-free.
– If both businesses are conducted by the parent, it can transfer one business to a subsidiary as a prelude to distribution of stock in the subsidiary.
– If Section 355 applies, in addition to the distribution being tax-free to shareholders, the distributing corporation does not recognize gain or loss.
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Distributions of Cash and Assets
Section 355 continued
When an S corporation is involved in a Section 355 division a Type D reorganization commonly will precede the division.
A division must involve a distributing corporation and one or more controlled subsidiaries.
No subsidiary can be an S corporation because the existence of a corporate shareholder will prevent qualification.
Only the distributing corporation in a Section 355 division can be an S corporation.
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Distributions of Cash and Assets
Section 355 continued
Where an S corporation owns all the stock of a subsidiary that is treated as a “disregarded” qualified subchapter S subsidiary, tax law ignores the existence of that subsidiary.
Regulations allow a parent S corporation to distribute the stock of a qualified subchapter S subsidiary in a transaction that qualifies under Section 355.
When an S corporation distributes all the stock of its qualified subchapter S subsidiary, the QSub status of the subsidiary will end.
The IRS allows former QSubs to elect immediately to become an S corporation.
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Distributions of Cash and Assets
Complete Liquidation of C Corporation. – The amounts received by a shareholder in complete
liquidation of a corporation shall be treated as full payment in exchange for the shareholder's stock so that the shareholder will recognize any gain or loss inherent in that stock.
– When a shareholder's debt to the corporation is canceled in connection with the liquidation, the amount of the debt is treated as part of the liquidating distribution.
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Distributions of Cash and Assets
Complete Liquidation of C Corporation. If a shareholder transfers stock to a donee or dies after the liquidation process has become irreversible, the weight of authority requires the gain to be reported by the donor or treated as income in respect of a decedent and taxable to the decedent.
Where a shareholder receives multiple distributions, he recognizes gain after all basis is recovered, but does not recognize loss until the final distribution is received.
Under certain circumstances, a shareholder may report his liquidation gain on the installment method as he receives payments from a third-party note that the corporation received on a liquidating sale of its assets.
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Distributions of Cash and Assets
Redemption of stock in C Corporation A stock redemption is the transfer of stock back to the issuing corporation in exchange for money or other property.
A stock redemption is treated as a sale of capital asset when it is essentially not a payout of earnings and profits as defined in the tax code. A redemption that does not meet that definition is treated as a dividend.
Sale treatment is beneficial to noncorporate shareholders and dividend treatment is beneficial to corporate taxpayers.
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Distributions of Cash and Assets
Partnership Distributions
• Partners are taxed on the current income of the Partnership whether or not the income is distributed to the partners.
• Current distributions that do not result in a termination of the partner’s ownership interest are not taxable to the extent they do not exceed he partner’s tax basis.
• Distributions of cash and securities that exceed the partner’s adjusted tax basis result in taxable gain.
• Distributions of cash or property within 2 years of contribution may result in a disguised sale.
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Distributions of Cash and Assets
Partnership Distributions
Liquidating Distributions
Distributions of income or Guaranteed payments not reliant on current income are taxable to the recipient either as a distributive share of partnership income or as a guaranteed payment.
In either case, the withdrawing partner generally realizes ordinary income while the continuing partners' share of partnership ordinary income is reduced.
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Distributions of Cash and Assets
Liquidating Distributions
Distributions other than the above. Cash liquidating distributions result in the recognition of capital gain or loss by the distributee to the extent the distributions are greater or less than the distributee's basis in his partnership interest.
Liquidating distributions in kind are not taxable to the partner provided that cash distributed does not exceed their adjusted tax basis in their partnership interest.
The partner can receive a in kind distribution in real estate and later exchange this property for another property tax free pursuant to Section 1031.
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Distributions of Cash and Assets
Liquidating Distributions
Distributions to all of the partners in liquidation of their interests as a tenancy in common.
Where the partnership distributes property:
– in liquidation of a partnership
– to the partners as tenants in common
– prior to entering into a purchase and sale agreement
– Then upon later sale of this property, the tenants in common may exchange this property.
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Distributions of Cash and Assets
Partnerships may select from a number of options in the withdrawal of a partner.
1. The sale of a withdrawing partner's interest to his co-partners terminates the partnership if 50 percent or more of the total interest in partnership capital and profits is sold within a twelve-month period.
2. The liquidation of a partner's interest by the partnership will not cause a termination provided at least two partners remain after the withdrawing partner's interest is completely
liquidated.
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Distributions of Cash and Assets
Trusts and Estate
Trusts share characteristics with corporations and partnerships.
1. A Trust and a decedent’s estate are separate taxable entities like a
corporation but may distribute its income to its beneficiaries.
2. A Trust may chose to be taxed like a corporation or a partnership, based
on the terms of the trust agreement, eg simple of complex trust.
3. Business Trusts are taxed like a corporation.
4. Current distributions of income to beneficiaries are taxed to the
beneficiaries and any remaining income not otherwise distributed is taxed
to the trust or estate.
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Distributions of Cash and Assets
Trusts and Estate
1. Distributions of Property by the trust before termination of the trust to the
beneficiary is not taxable to either the trust or the beneficiary.
2. Revocable trusts also known as Grantor trusts for income tax purposes
are treated as owned by the individual that established the trust and
retained the right to make changes to the trust governing document and to
distribute property back to the individual, known as the grantor. In the
context of 1031 exchanges, the grantor of the property to be sold is treated
as the true owner of the relinquished property and may, at his or her
designation, acquire replacement property, in the name of the grantor trust,
in the name of another disregarded entity, such as a single member limited
liability company, or in their own name.
3. There is no gain or loss on the distribution of assets to the grantor of the
trust.
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Inheritance & Intestate Succession
1. When a shareholder or partner dies, the shares or partnership interest may
be subject to a buy-back agreement.
2. In the absence of a buy-back agreement, the shares or partnership interest
will pass according to the shareholder’s testamentary instructions (i.e.,
will or trust) or by state intestate succession.
3. In the event that there is no buy back agreement the IRS can value the
business interest in accordance with their expert valuation. Obviously this
is a result that should be avoided
4. IRC § 1014 provides a step-up in basis equal to the FMV of the shares or
partnership interest at death.
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Inheritance & Intestate Succession
Trusts, like corporations and partnerships, are not
terminated at death.
A revocable trust will become irrevocable at the death
of the last grantor.
The trust (and ultimately the beneficiary if assets are to
be distributed) receives a stepped-up basis equal to
FMV in the assets pursuant to § 1014.
An irrevocable trust is unaffected by the death of a
grantor.
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Estate Taxation of Business Interests
• It is important to note that the estate tax is borne by the decedent’s estate, it
is not a tax that applies to corporations, partnerships or trusts.
• Shares in a corporation, partnership interests, assets contributed to a
revocable trust, and beneficial interests in an irrevocable trust are includible
in a decedent’s gross estate.
• Note, that if the decedent’s shares or partnership are subject to a buy-back
arrangement, the shares or partnership interest are not included in the
decedent’s gross estate b/c they are no longer property held by the decedent
at the time of death. Nevertheless, the proceeds from the sale pursuant to
the buy-back agreement will be included in the decedent’s gross estate.
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Valuation of Business Interests
• The question of what property or interest is to be included in
the gross estate of a decedent is a question separate from the
valuation to be placed on the included property or interest.
• If property is included in the gross estate of the decedent the
value used shall be the value at the date of death, unless the
executor elects the alternate valuation date.
• In general, property included in the gross estate is valued at its
FMV at the time of the decedent’s death (or on the alternate
valuation date under § 2031).\
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Valuation of Business Interests
Stocks are valued at their fair market value per share on the applicable
valuation date.
FMV is based upon selling prices where possible and otherwise on bid
and asked prices. Treas. Reg. § 20.2031-2(a) – (d).
Fair market value is determined by taking into account the company’s net
worth, prospective earning power, and dividend-paying capacity.
Partnership interests are also valued at fair market value.
In valuing a closely held business, substantial discounts or premiums can
apply based on lack of marketability and control (or acquiring control).
Federal Estate tax rules provide elaborate special valuation rules for
certain transfers between family members of interests in corporations,
partnerships and trusts.
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Strategies to Consider
• For family owned business, transition planning is critical.
• In terms of planning, it is key to analyze the client goals in light of current IRS litigation strategies. IRS attacks on Entities can be summarized as follows:
– challenge entity reality, in order to value directly the underlying assets, especially now using Section 2036(a); and/or
– attack valuation methodology employed to develop valuation discounts.
• The following slides are examples of the more common tax strategies that
any family business owner should consider:
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Converting to S Corporation status to avoid double taxation
When C Corporations distributes appreciated assets to its shareholders, the C Corporation and the shareholder are taxed on the distribution.
In order to avoid the double tax a C Corporation can elect to be treated as an S Corporation.
The S corporation is subject to this double tax until the expiration of the a ten-year period after the S corporation conversion date.
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Getting assets out of a C Corporation to avoid double taxation
Purchasing a certain term lease and remainder interest in real estate
– The corporation and shareholder jointly purchase land and building. The corporation purchases the leasehold and the shareholder purchases the fee interest subject to the lease.
– At the termination of the lease term, the fee interests is held in the name of the shareholder transfer free of the corporation’s interest.
– Term interest is defined as a life interest in property, an interest in property for a term of years, or an income interest in a trust. This includes an interest, present or future, in the income from property or the right to use property which will terminate or fail on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur.
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Bramblett Transactions may be used to preserve capital gain rates for Real Estate developers
Certain assets, such as real estate, are generally taxed as capital gains when held for at least one year and one day and held for trade or business or investment.
In certain cases where the taxpayers subdivide and develop their real estate and sell it piecemeal, all the resulting income may be ordinary, such as land subdivided for sale as lots and with apartments converted to cooperative or condominium units.
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Bramblett Transactions (cont.)
With advance planning the sale of property by taxpayers to their controlled corporation can preserve capital gain treatment for the existing appreciation while giving the taxpayers the economic benefits of future development.
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Example of Bramblett Transactions
A and B hold undeveloped land for investment. The land has a basis of $200 and is worth $1,000. A and B sell the land to their S corporation for $300 cash and a $700 note. The corporation then subdivides the property and reports any proceeds in excess of $1,000 as ordinary income. A and B properly report capital gain from their sale possibly on the installment method.
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Disappearing Equity
Trade or give to the older generation an asset that is worth more to inheriting party than to market. This is treated much like a family partnership and should not be a current gift. A concurrent interest is not covered by “anti-freeze” rules. Care must be taken so that tenants-in-common interest is not recast as a de facto partnership. Father and daughter each exchange separately owned relinquished property for tenants-in-common interest in a single replacement property. Upon father’s death, estate values property taking a lack-of-marketability and minority discount. In another example Father transfers relinquished property in a deferred exchange. Daughter acquires a fee interest in potential replacement property. In “build-to-suit” exchange, Father (through QI) simultaneously acquires long-term leasehold interest and QI constructs leasehold improvements as replacement property. The leasehold interest is in effect a “wasting asset” so that value will decrease over time. At lease termination the daughter(as fee owner) will acquire leasehold improvements without recognition of taxable income.
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Income shifting and Asset transfer
• Family Partnerships.
– Section 704(e) provides that a person will be recognized as a partner if he owns a capital interest in a partnership in which capital is a material income producing factor, whether or not the interest was derived from purchase or gift from any other person.
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Income shifting and Asset transfer
• Family Partnerships. Able and Annette gift 50% of their partnership interests owning an apartment building to their son Baker in an amount less than the unified credit. Baker will receive 50% of the taxable income and 50% of the future appreciation.
Alternatively, Able and Annette could grant their son a profits interests in the partnership to manage the property because Able and Annette are moving to Arizona for retirement. Baker earns 10% profits interest per year, which is not taxable upon receipt.
Baker has the right to convert the profits interests to capital interests after 10 years, provided he is able to manage the property to earn a compounded 10% rate of return.
Note that the IRS has issued Proposed Regulations in 2005 which are pending.
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Income shifting and Asset transfer
• Family Partnerships. The receipt of partnership profits interest for future services by Baker is not taxable to Baker unless either (a) the profits interest relates to a “substantially certain and predictable stream of income from partnership assets” such as a triple net lease property or (b) within two years of receipt, the partner disposes of the profits interest.
Baker is taxed on his partnership income each year and any undistributed income is added to his capital account.
Under the 2005 Proposed Regulations, Baker would be protected from taxation only if the partnership and all of its partners affirmatively elect a “safe harbor” designating the fair market value of the profits interest is equal to the liquidation value of that profits interest ( zero). Additionally, Baker is required to file a Section 83(b) election.
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Income shifting and Asset transfer
• Family Partnerships. In the event that the Partnership decides to sell its interest in the apartment building, Baker can elect 12 months and a day before the sale to convert his profits interests earned to date to a capital interest. Baker would be taxed on the conversion to a capital interest, but would be able to use his share of the proceeds to pay the taxes on the conversion.
The income would be treated as a guaranteed payment, deductible to to the partners Able and Annette. ( 2005 proposed regulations).
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Income shifting and Asset transfer
• Family Partnerships.
– Section 704(e) provides that a person will be recognized as a partner if he owns a capital interest in a partnership in which capital is a material income producing factor, whether or not the interest was derived from purchase or gift from any other person.
• Family Limited Partnerships
• Intentionally defective Grantor Trusts
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Gifting reduces overall transfer taxes
1. Bill and Beth retired after long careers culminating in their ownership and management
of Successful Corp. Their net worth is $10 million, which is more than sufficient to
maintain their lifestyle. The value of their shares in Successful Corp. is $5 million. The
value of their shares is growing at 5% per year. Bill and Beth can significantly reduce
their taxable estates by making annual $28,000 exclusion gifts to each of their 4 children
per year.
2. Alternatively, Bill and Beth, whose remaining life expectancy is 10 years, can gain a
additional transfer tax saving by making a gift of their entire amount of shares to their
children. Assuming the gift’s value in 10 years would be $8,144,473.13, making the
current gift removes $3,144,473.13 of future appreciation from their estate – resulting in
about $800,000 of transfer tax savings.
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Freezing Future Appreciation
Recapitalization
No Limits Corp. (NLC) is currently owned by Master P. (600 shares of common stock), his
son, ‘Lil Romeo (300 shares of common) and his wife Foxy Brown (100 shares of common).
NLC enters into a plan to recapitalize the company as follows:
1. Master P will exchange his 600 shares of common stock (which will be retired) for 600
shares of voting preferred stock.
2. This plan provides Master P a steady source of income and assures him voting control
over NLC operations, while causing the growth in value to accrue to ‘Lil Romeo and
Foxy Brown.
3. To assure that the IRS will respect the valuation, the Company and its shareholders will
enter into a buy sell agreement fixing the value of the preferred stock at the death,
disability, or retirement of Master P.
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Examples
• Section 355 division to separate corporate assets for nest generation
– Can’t Stop Won’t Stop, Inc., (CSWS) is a closely held business whose three shareholders
are Bob, the 72-year-old founder and controlling shareholder, and his son-in-law Jim and
nephew Nick, who own equal minority interests. CSWS has two businesses, Hot Dogs on
a Stick, which sells ice cream, and Frozen Frosties, which sells refurbished
transmissions. To resolve a dispute between Jim, who manages Frozen Frosties, and
Nick, who is in charge of Hot Dogs on a Stick, over long-term allocation or resources b/t
the businesses, the shareholders decide to divide the businesses in a D reorganization.
– Accordingly, CSWS transfers the Frozen Frosties business to a newly formed company
in exchange for its stock, which is distributed to Bob and Jim, and CSWS continues to
run Hot Dogs on a Stick (w/ Bob and Nick continuing as shareholders). Provided the
statutory requirements are otherwise met, the reorganization is a tax-free transaction,
helps resolve the operations dispute, and allows Bob to start easing out of CSWS w/out
sacrificing his personal and professional relationships with both Jim and Nick.
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